Question 3 (a)
Why market value weights are superior to book value weights
3 marks
- Time to write
- About 6 minutes
- Topic
- Cost of capital
Question
Question 3 (a) · 3 marksWhy are weights at market value superior to weights at book value?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- WhyReasons, not a description: each reason explained in a line or two.
Write it in this order
- 1 Current values rather than historical cost 1 mark 2 min
- 2 Verdict and reason capital structure as investors value it 1 mark 2 min
- 3 Relevance to investors' required return 1 mark 2 min
Try it first. About 6 minutes for 3 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
In computing the weighted average cost of capital, the weights may be taken at book value or at market value. Market value weights are regarded as superior for these reasons:
- They show the present, not the past. Book values rest on historical cost and do not reflect the firm's current position or its prospects. Market values are based on the current prices of the firm's securities and reflect present market conditions.
- They represent the firm's true capital structure. Market value weights are more correct and represent the capital structure as investors value it; the market value represents the true value to investors.
- They are relevant to investors. The cost of capital is the return investors require on what their holding is worth today. Market values reflect the market's view of the company's value, so they are more relevant to investors than book values.
Limitation. Market values fluctuate and are harder to obtain, and they give greater importance to equity, which is why book values are sometimes used in practice.
Where the 3 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Current values rather than historical cost | 1 |
| 2 | True capital structure as investors value it | 1 |
| 3 | Relevance to investors' required return | 1 |
| Total | 3 |
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